Journal of Real Estate Finance and Economics, 21:2, 95±111, 2000
# 2000 Kluwer Academic Publishers. Manufactured in The Netherlands.
Embedded Options in the Mortgage Contract
BRENT W. AMBROSE
Center for Real Estate Studies, Gatton College of Business and Economics, The University of Kentucky,
Lexington, KY 40506-0034
RICHARD J. BUTTIMER, JR.
The University of Texas at Arlington, Arlington, TX 76013
Loss mitigation is the process by which lenders attempt to minimize losses associated with foreclosure. As
competition increases in the mortgage industry, lenders and servicers are under great pressure to adopt loss
mitigation tactics rather than simply use foreclosure as the means of dealing with borrowers in default. This study
presents a mortgage-pricing model that fully speci®es all borrower options with respect to default, including the
ability to reinstate the mortgage out of default. We document the impact of various loss mitigation programs,
including forbearance and antide®ciency judgments, as well as the value of credit on borrower default behavior.
Key Words: mortgage pricing models, default, foreclosure, loss mitigation
[Early Indicator] is a tool to identify delinquent loans that stand the highest risk of
foreclosure. Early Indicator enables servicers to intervene before borrowers reach a
point of no return. It lets servicers target scarce resources to the borrowers most in need.
ÐLeland C. Brendsel,
Chairman and CEO, Freddie Mac
Competition in the servicing industry and the resulting squeeze on pro®t margins is
spurring the development of new sources of operating ef®ciencies. As a result, the
mortgage industry is rapidly developing loss-mitigation systems designed to allow
mortgage servicers to identify and manage delinquent borrowers who have the greatest
risk of going to foreclosure. For example, both Fannie Mae and Freddie Mac have
developed automated mortgage scoring models designed to identify borrowers with the
greatest likelihood of going into default. In addition, the Department of Housing and
Urban Development (HUD) rates mortgage servicers based on their default losses and
loss-mitigation successes, giving incentives for servicers to actively engage in reducing
default losses. Utilizing these models, it is hoped that mortgage servicers will reduce the
losses associated with borrower default. However, a major concern with implementing